Market Efficiency - Financial Management

A central theme of much of the academic finance and financial economics research since the 1960s has been the efficiency of the capital markets. The more efficient capital markets are, the more likely it is that resources will find their highest (risk -adjusted) return uses. Capital market efficiency is an implicit assumption in many decision models widely used in finance. Consequently, this concept is important to a full understanding of these decision models.

In an efficient capital market, stock prices provide an unbiased estimate of the true, or intrinsic, value of an enterprise. Stock prices reflect a present value estimate of the firm’s expected cash flows, evaluated at an appropriate required rate of return. The required rate of return is determined by conditions in the financial markets, including the supply of funds from savers, the investment demand for funds, and expectations regarding future inflation rates.

The required rate of return on a security also depends on the seniority of the security, the maturity of that security, the business and financial risk of the firm issuing the security, the risk of default, and the marketability of the security. The efficiency of the capital markets is the important “glue” that bonds the present value of a firm’s net cash flows —discounted at the appropriate risk -adjusted required rate of return —to shareholder wealth as measured by the market value of a company’s common stock.

Hence, in this section of the chapter, the concept of market efficiency is defined, the evidence regarding the extent of capital market efficiency is reviewed briefly, and some important implications of market efficiency are identified.

Information and Capital Market Efficiency

Capital markets are efficient if security prices instantaneously reflect in an unbiased manner all economically relevant information about a security’s prospective returns and the risk of those returns. What is meant by “all economically relevant information”? Information is a message about future events that may occur. Relevant information can be used by an individual to take actions that will change the welfare of that individual. Messages that an individual cannot act upon to change his or her welfare have little value.

For example, a cotton farmer who grows cotton on irrigated land might be willing to pay for accurate weekly rainfall forecasts, because these forecasts can be used to establish the most efficient irrigation schedule. In contrast, once a dry-land cotton farmer has planted his fields, weekly rainfall forecasts are of little use, because there are no actions the farmer can take on a day-to-day basis using this information. In addition to being able to act upon the information in a manner that will affect one’s welfare, one must be able to correlate the information with the future events when they occur.

For example, if your broker always told you that a stock you had identified looked like a “good buy,” this message would have little value to you, because you know that some of these stocks will perform well and others will not. In contrast, if your broker recommends stocks to buy and stocks to sell based upon his or her estimate of each security’s return prospects and is right more often than he or she is wrong, then this message constitutes economically relevant information.

In security markets, some messages are economically relevant to investors and others are not. If a message has no impact on the future return or risk prospects of a security, it is not relevant to investors and should not be correlated with security performance; that is, it does not constitute information. For example, the news that a company has changed the format of the presentation of its financial reports is not information because this cosmetic change has no impact on the return or risk of that company’s securities.

In contrast, if the company announces that it has adopted a new accounting convention that will result in significant tax savings, this news is information because it affects the return stream from that company’s securities.
Another example of market efficiency is the reaction to earnings releases. Firms periodically release information on their actual earnings or forecasted earnings.

If the earnings information released is different from what the market expected, then there is likely to be a significant stock price reaction. If the market is efficient, the stock price should react to this announcement within a few moments of its release. If it takes several days or even a few hours to fully absorb this information, then the market may be considered to be inefficient. Inefficiency implies that one can easily buy shares of this stock upon announcement and sell it a few hours or few days later and earn an abnormally high return. To illustrate the market efficiency phenomenon, consider the example of Merck & Co., which announced on December 11, 2001, that their earnings per share for 2002 would be less than anticipated.

Specifically, management revised their earnings per share projections downward to $3.02—considerably lower than the $3.40 earnings per share analysts had projected. As a result, analysts and other investors assigned Merck stock a lower valuation. This decrease in stock value was reflected very quickly in the stock price.

We shows a chart of the daily price (high –low range and closing prices) of the stock for several days on either side of December 11, 2001, when Merck announced its revised projections.Note that in the days prior to the announcement date the stock prices hovered in the $66–$68 range. On the day of the announcement, there was a downward spike with the stock price closing at $60.70, which is 9.4 percent lower than the previous day’s closing price of $66.99. Thereafter,Merck’s stock price appears to move randomly about a new equilibrium price level in the range of $58–$59.

Note that the stock price did not take several days to completely react to the negative news release on December 11; rather, the stock price seems to have reacted swiftly on the day of the news release. If markets are inefficient, or slow to react to new information, a person could easily attain abnormal profits by trading on the stock after the release of information. Specifically, if the information is positive you would buy the stock when the information is released and then sell it a few days later after the stock has risen to its new equilibrium level.

You can also profit from negative news releases by selling the stock first and then buying it back a few days later when the stock has settled to a new lower level. The latter type of transaction is called short -selling. In a short sale, you essentially sell a stock that you do not own by “borrowing” it from another investor (this is done by the stockbroker on your behalf) and then replacing it later by purchasing it, presumably, at a lower price.

Degrees of Market Efficiency

Three levels of market efficiency have been identified based on the information set under consideration: weak-form efficiency, semistrong -form efficiency, and strong-form efficiency.

Daily Stock Prices for Merck & Co. Around Forecasted Earnings Announcement

Daily Stock Prices for Merck & Co. Around Forecasted Earnings Announcement

Weak -Form Efficiency

With weak-form market efficiency, no investor can expect to earn excess returns7 based on an investment strategy using such information as historical price or return information. All stock market information, including the record of past stock price changes and stock trading volume, is fully reflected in the current price of a stock. Tests of the weak-form market efficiency hypothesis have included statistical tests of independence of stock price changes from various day -to-day periods.

8 These studies have concluded that stock price changes over time essentially are statistically independent and that a knowledge of past price changes cannot be used to predict future hanges.Other tests have looked for the existence of longer-term cycles in stock prices, such as monthly or seasonal cycles. In addition, numerous trading rules based solely on past market price and volume information have been tested. Pinches, in a review of much of this research, has concluded that “with some exceptions, the studies of mechanical trading rules do not indicate that profits can be generated by these rules.”10 In conclusion, the evidence indicates that U.S. capital markets are efficient in a weak -form context.

Semistrong -Form Efficiency

With semistrong -form market efficiency, no investor can expect to earn excess returns based on an investment strategy using any publicly available information. Announcements of earnings changes, stock splits, dividend changes, interest rate changes, money supply levels, changes in accounting practices that affect a firm’s cash flows, takeover announcements, and so on, are quickly and unbiasedly incorporated in the price of a security.

A finding of semistrong-form market efficiency implies that the market is also weakly efficient because the information set considered in the weak-form case is also publicly available. Once information is made public in a semistrong -form efficient capital market, it is impossible for investors to earn excess returns (after considering trading costs) from transactions based upon this information because the security price will already reflect the value of this information.Studies of stock splits, new issues, stock listing announcements, earnings and dividend announcements, stock acquisition announcements, and announcements of analyst recommendations support the notion of semistrong-form market efficiency, at least after the cost of commissions on transactions is considered.11 There have been a few apparent observed violations of semistrong-form market efficiency, but in many cases, alternative explanations for these exceptions have been found. Overall, the evidence on semistrong-form market efficiency tends to support this level of market efficiency.

Strong-Form Efficiency

With strong -form market efficiency, security prices fully reflect all information, both public and private. Thus, in a strong-form efficient capital market, no individual or group of individuals should be able to consistently earn above -normal profits, including insiders possessing information about the economic prospects of a firm. The existence of individuals, such as investment banker Dennis Levine (see “Ethical Issues” section), who have traded illegally on the basis of inside information and have earned phenomenal profits until they were caught and prosecuted by the Securities and Exchange Commission, provides graphic evidence that strong-form efficiency does not hold.

Implications of Market Efficiency for Financial Managers

In general, we can conclude that capital markets are quite efficient, both in an informational and an operational sense. The observed efficiency of capital markets has some very important implications for financial managers.

Timing or Gambling

In a weak-form efficient capital market, we know there are no detectable patterns in the movement of stock and bond prices. Companies often indicate that they have delayed a stock or bond offering in anticipation of more favorable capital market conditions; that is, a higher stock price or lower interest rates. Since there are no predictable patterns of stock price and interest rate movements over time, financing decisions based upon improved market timing are not likely to be productive, on average. If a stock has traded as high as $30 per share recently but is now trading only at $28, management may delay a proposed new stock issue in anticipation of a higher future price.

If this delay is based upon a market timing argument —such as “the market is now temporarily depressed”—rather than on some inside information known only to management that suggests that the stock is currently undervalued, then the strategy is not likely to be successful. In some instances, the stock price will increase in the direction of the target, while in the Publication of Second-Hand Information,” Journal of Business (January 1978):

others, it will decline even further. In weak -form efficient capital markets, financial decisions based on timing market cycles are not able to consistently lead to higher returns than are available to managers who do not attempt to time their financial decisions to take advantage of market cycles.

An Expected NPV of Zero

In an efficient capital market, all securities are perfect substitutes for one another, in the sense that each security is priced such that its purchase represents a zero net present value investment. This is another way of saying that required returns equal expected returns in efficient capital markets. For example, if you buy one share of Apple Computer stock for $25, the present value of the market expectation of its cash flows is equal to $25.

Hence, this purchase has a net present value of zero. If you buy for $35 one share of stock in Duke Energy, a diversified energy firm with considerably less risk and lower earnings growth prospects than Apple Computer, the present value of the market expectation of its cash flows is equal to $35. The difference between the risk and expected returns of the two companies’ stocks is reflected in their market prices and the discount rate used by the market to evaluate the expected future cash flows.

Only if an investor possesses information that is not known to the marketplace—for example, insider knowledge of a major new oil strike by an oil firm or of a pending takeover attempt— will the investment in a stock or bond have a positive net present value.

Expensive and Unnecessary Corporate Diversification

If capital markets are efficient and all securities are fairly priced, on average, investors can accomplish much on their own without the help of a firm’s financial managers. For example, consider Eastman Kodak’s acquisition of Sterling Drug. In 1988, Eastman Kodak paid $89.50 per share to acquire Sterling Drug. During the previous year, Sterling traded for as little as $35.25 per share.

As a stockholder of Eastman Kodak, you could have achieved the same diversification in your portfolio simply by buying shares of Sterling Drug in the open market.In spite of this, financial managers of many firms continue to make acquisitions of other companies in order to achieve “the benefits of diversification.” In efficient capital markets, this type of activity is better left to individual investors.

Security Price Adjustments

In efficient capital markets, security prices reflect expected cash flows and the risk of those cash flows. If a transaction, such as an accounting change, does not impact the firm’s expected cash flows or the risk of those cash flows, then the transaction should have no impact on security prices. Investors are not fooled by cosmetic accounting or other nonmaterial transactions.

Efficient capital markets research has shown that accounting format changes having no impact on a firm’s cash flows do not result in changes in the firm’s value. Actions such as including the capitalized value of financial leases on a firm’s balance sheet, providing an inflation-adjusted income statement and balance sheet, company name changes, stock splits, and stock dividends unaccompanied by a rise in earnings and/or dividends have no significant impact on stock prices.

In contrast, any event impacting actual cash flows —such as a change in inventory valuation designed to reduce tax obligations —or the risk of these cash flows —such as an announcement by a public utility company that it will sell all of its nuclear power plants—will be reflected quickly in the stock price. Prices in efficient capital markets have a story to tell. For example, on December 17, 1986, Republic Bank Corporation of Dallas announced plans to acquire InterFirst Corporation.

InterFirst was suffering from severe loan portfolio quality problems at that time due to the energy sector downturn and a real estate glut in its major market areas. On the day following the announcement, the stock price of InterFirst declined from $5 to $4.875 per share. The stock price of Republic declined from $21.75 to $19 per share. The market’s assessment of this acquisition was not positive. Indeed, the market’s early assessment appears to have been correct. In early 1988, First Republic’s stock traded for $1.75 per share. The bank failed shortly thereafter.

The response of the market to the proposed acquisition of Compaq Computer by Hewlett -Packard (H-P) in 2001 also suggests that this combination might not be value enhancing. On the date of the merger announcement, the price of H-P stock fell by 19 percent to $18.87, a $5 billion decline in the market value of the company’s stock, and Compaq’s price fell by 10 percent to $11.08.

Behavioral Finance Perspectives on the Financial Marketplace

In spite of an extensive body of literature indicating that the capital markets in the United States and other financially sophisticated economies are highly efficient, these markets are not perfectly efficient. We continue to find anomalous events that are inconsistent with fully efficient markets. For example, the speculative “bubble” of the late 1990s that saw the runup in prices of Internet stocks and their subsequent decline indicates trading behavior that may not be consistent with fully rational investment decision making. These anomalies have led to the development of new financial models suggesting that investors sometimes behave irrationally.

Behavioral finance seeks to understand how departures from totally rational decision making by investors and other market participants can help to explain otherwise curious market occurrences.13 Various psychological considerations may lead to market inefficiencies. One example is the refusal by some investors to sell a losing stock, since it means giving up hope and admitting that the investor made a mistake in purchasing the security.

Another example is fixating on a price target for a stock (or the market) and filtering out evidence that the investor (or analyst) may be wrong. A final example is the tendency for some investors to focus too heavily on up or down price trends.As a consequence, the investor tends to extrapolate past performance too far into the future. There is growing evidence that behavioral approaches to understanding market prices have some merit. However, most researchers believe that, over the long run, securities markets are efficient; that is, the market price of a company’s stock represents an unbiased estimate of the intrinsic value of the company.


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